Is There Any Hope for Emerging Markets?

Emerging US Stocks

Emerging market stocks have been among with worst-performing asset classes this year. While so far in 2015 US stocks are down slightly and international developed stocks are slightly up, emerging market stocks have lost more than 12%. And this isn’t a new phenomenon: in 3 of the previous 5 calendar years emerging market stocks have dramatically underperformed their US counterparts. Is there any hope for this battered asset class?

Part of the problem for emerging markets has been declining economic growth prospects. The International Monetary Fund recently lowered its growth estimates for Latin America and Southeast Asia, and it projects that China’s economic growth rate will continue declining. With emerging economies stagnating while growth rates in developed economies are projected to increase, emerging markets seem like a less compelling investment opportunity.

Another part of emerging markets’ problem has been the US dollar, which has soared in value since the middle of last year. A stronger US dollar directly hurts the value of US investors’ emerging market holdings, which are worth less when converted back into dollars. But it can hurt emerging markets in other ways as well. A strong dollar tends to be associated with lower commodity prices, which hurt the many emerging economies that export commodities. And many emerging markets have debts denominated in US dollars, which are harder to repay when the dollar increases in value.

Given these problems, emerging market stocks may seem like a lost cause. But the flip side of poor performance for an asset class is lower valuations, which can improve the prospects for the asset class going forward. The valuations on emerging market stocks overall are below their historical averages and far below the valuations on US stocks and international developed stocks.

Valuations don’t provide much information about what will happen in the short-term, so it’s certainly possible the emerging markets could continue to underperform for a while. Though below their historical average, emerging market valuations are also still above the nadir they reached in 2008, suggesting that another extreme event (such as China’s recent turmoil turning into a full-blown financial crisis) could lead to further declines. But if they’re able to avoid economic upheaval, emerging markets seem well-positioned to finally end their losing streak.